HMRC increases VAT recovery for DB pension investment costs

Until the recent change in policy, HMRC's position meant that it was far easier for employers to recover input tax on costs relating to the administration of DB pension schemes than on investment costs relating to management of the scheme's assets.

Input tax on administration service costs could be recovered by the employer as a business overhead, provided the VAT invoice was addressed to it - even if the pension fund trustee contracted and paid for the relevant services. This is not a 'normal' VAT invoicing arrangement; employers are able to do this because HMRC guidance expressly permits it in respect of administration costs.  By contrast, input tax on investment costs could only be recovered in that way if the employer contracted and paid for the services itself.  However, as the trustee would typically (for non-tax reasons) be required or want to be party to the fund management contract, it was necessary to put complex arrangements in place to access this input VAT recovery.  These included:

1) Tripartite contracts – this involved the services being provided under a tripartite contract between the service provider, the trustee and the employer. Although this route could lead to all the input tax being treated as the employer's, it was difficult to implement and is rarely used.

2) VAT grouping – this involved bringing the trustee into the employer's VAT group, such that input tax incurred on investment services was treated as belonging to that group. This meant that recovery was possible in accordance with the group's partial exemption recovery method – but at the cost of the trustee's presence in the group typically reducing the group's recovery percentage under that method. In addition, HMRC took the view that the investment services had a "dual use" - they were used both for the group's general business purposes AND for the trustee's investment activities, with input tax recovery only being possible for the former use. The apportionment between the uses was to be on a fair and reasonable basis (50% is often cited as a common figure – such that 50% would then be recoverable in accordance with the VAT group's partial exemption recovery method).

3) On-supply - this involved the trustee registering for VAT and making a taxable supply of scheme administration services to the employer (with the investment services received by the trustee forming part of that on-supply). However, as with the VAT grouping route, HMRC took the view that there was a "dual use" to those investment services – this time between the trustee's taxable supply to the employer and its ongoing investment activities, such that again, commonly only 50% of any VAT thereon would end up as recoverable.

HMRC has increased the scope for recovery of input VAT on investment costs. However, the business brief announcing the policy change leaves a good deal of uncertainty.  We think that, essentially, there are two ways of interpreting it:

1) The silver standard: abolition of the "dual use" concept only – This is in our view the most natural way to read the brief, and would mean that to get the best input VAT recovery position it would still be necessary to use one of the arrangements described in the Background (above) but that this would now result in up to 100% of input tax (rather than, for example, 50%) being recoverable.

2) The gold standard: investment costs to be treated the same as administration costs – This would allow an employer to recover up to 100% of the input VAT as a business overhead on investment services, provided the VAT invoice was addressed to it (even if the trustee contracted and paid for the services).

Somewhat unhelpfully, HMRC has said that the change has effect from the day of the brief (18 June 2025) but that we need to wait for the explanatory guidance, which should be with us by autumn 2025.  This raises the question of what, if anything, trustees and employers should do in advance of clarity being provided in the guidance.  This issue is particularly acute in relation to potential claims for additional input tax recovery from prior VAT periods – which the brief indicates should be possible – as these are subject to a four-year lookback time limit.  If you would like more information on how the lookback applies, please do get in contact.

The brief also says that businesses may need to propose new partial exemption special methods (PESMs) to align their VAT recovery with the new policy (and that any new PESMs approved by HMRC will take effect from the start of the tax year in which the PESM was submitted). Without the detail of the new policy, it is unclear how it will impact PESMs. This is something to watch out for when we get the final guidance.

Schemes that are using, or have used, the VAT grouping or on-supply routes

As the dual use concept has been abolished, the benefit of either of these routes will have increased. As it seems that HMRC is open to input tax claims for prior periods, employers (in the case of the VAT grouping route) and trustees (in the case of the on-supply route) should act promptly to make claims for periods in relation to which the four-year lookback period is set to end soon.

For current VAT accounting periods, employers (in the case of the VAT grouping route) and trustees (in the case of the on-supply route) should seek to recover all of the VAT on investment costs.

If, in due course, the guidance reveals that HMRC's policy is the gold standard (i.e. treating investment costs in the same way as administration costs), then schemes should consider unwinding the VAT grouping or on-supply arrangements (given that the former typically depresses the employer group's partial exemption recovery rate and the latter is complex and can have cashflow costs) and instead simply have the invoices addressed to the employers.

Schemes that are not using the VAT grouping or on-supply routes

If HMRC's policy turns out to be the gold standard, then trustees and employers should discuss changing their invoicing arrangements with the investment service provider so that invoices are addressed to the employer.

If HMRC's policy turns out to be the silver standard (abolition of the dual use concept only), trustees and employers should reconsider the VAT grouping or on-supply routes, given that the benefit of either route is likely to have significantly increased.